Lifting of pandemic restrictions has generated an overly enthusiastic view that economically sensitive companies will rebound quickly across many business sectors. Insync deliberately has no exposure to stocks of this ilk. We favour companies that are not only are some of the most profitable companies in the world but are also expected to consistently grow their earnings at high rates regardless of how the global economy performs. 

As the earnings growth across our portfolio continues to compound at high-rates, the gap grows ever wider between their stock price and their valuations (currently circa 50%+ below valuations). In these shorter periods of relative underperformance, a tension permeates in markets. This creates ideal conditions for entry as a sudden 'snap-back' in stock prices can occur very quickly. Snap backs are triggered by a change in market conditions, an event or simply the market recognizing the big disparities between the companies promising to deliver to the ones actually delivering.

We liken it to an elastic band. The more you stretch it (the widening of the gap between valuation and share price), the greater the likelihood of a rapid 'snap-back'. Whilst it's impossible to time exactly when the snap back will occur, when it does do so, it delivers strong outperformance to those stocks with the real underlying earnings and profits to support a sustainable uptick in their price. At the same time, the reverse occurs for those presently leading this latest bout of exuberant price growth.

We like value but we are not value Investors.

We recently had an extensive meeting with a fund researcher where we took him through our valuation approach. One of his key conclusions was that Insync is a 'value investor'.

Whilst we would not describe ourselves as value investors based on conventional metrics (just buying companies based on low Price/Earnings ratios), an important part of Insync's process includes building a high degree of confidence in understanding the worth of a company's future cashflows beyond its present state.

To make money involves finding companies where the value we see is significantly greater than the price we have to pay. The current investor exuberance around

chasing returns in hyped up sectors has the Insync portfolio of quality growth companies trading at circa 50% below our assessed valuations.

A question to ponder is this.....

Would you buy into highly profitable businesses if you could buy them at such a large discount? And after doing all your investigations and crunching the numbers, its forward earnings were compounding strongly. Or would you buy a very richly valued popular business whose forward looking numbers don't support its price but everyone was enthusiastic about it today? This is the choice that investors face and this sets up perfect conditions for the Insync portfolio to deliver strong returns.

P.S. Insync is of course categorised as a 'Quality Growth' Investor.

Traditional valuation metrics are losing their predictive power.

PE (Price/Earnings) and PB (Price/Book) ratios have been declining in their ability to predict value. The main reason is in the "E" part of the P/E ratio.

Our modern global economy is increasingly driven by intangible assets. Items such as intellectual property, R&D, brands, and networks. In the last decade or so this has accelerated to dominate in many key industries. In the past capital equipment and other tangible assets used to figure large on balance sheets.

'Intangibles' now represent 84% of the market value of the S&P 500 as depicted above. The old focus supported the old P/E and P/B ratios suitability. The problem occurs when it is applied to this new world - to the industries and companies that invest heavily in intangibles. It creates a misleading and distorted picture.

By example, when Pfizer invests R&D in a new drug for Covid-19 (forecasted to generate sales of US$45.7 Bn this year), or Amazon spending on building their cloud capability (sales of US$60 Bn expected from this division), these investments are classified as intangibles.

They have to be expensed through their income statements. This means it significantly depresses their earnings today despite these 'investments of expenditure' creating significant sales and profits for many years to follow. Their resulting P/E and P/B ratios are thus negatively impacted. This is important to remember when investing for the future. Beware of using the rear-view mirror. Life has changed. Fastest decline in history.

By way of contrast, old-industry companies, say a steel company, has to invest heavily in property and machinery (tangibles). The accounting rules treat these investments as capital expenditures. It immediately goes onto the balance sheet and does not detract from that year's earnings unlike intangibles. Effectively this inflates its present earnings and the book value. P/E and P/B ratios look good.

This inconsistent treatment of the drivers of future growth between intangibles and tangibles leads to wrong conclusions on what actually represents good value and what does not. P/Es are thus not a useful indictor for industries with high intangibles, and even more misleading if taking an average across a broad index.

Conventional portfolio blending methods.
Passed their Used By date?

Many research houses lump funds managers into simplified groupings primarily based on P/E ratios.

Growth managers tend to be holding businesses with higher than market average P/E or P/B ratios. Value managers holding a portfolio of low P/E ratios, and GARP or Core managers somewhere in-between.

Not only is this old measure being over-used to compare managers in the same group, it is further adapted as the primary means of blending managers across entire client portfolios and investment models. People tend towards simplicity even if its misleading. Given the change in intangible expenditures this is an increasingly unwise approach for professional advice givers. It is also worth noting that P/B and P/E ratios represent two of the three variables used to determine stock inclusion in the widely followed style index, MSCI World Value.

The key driver of future earnings - intangibles, is not being appropriately reflected in the income statements and balance sheets in a rapidly changing economy. Accounting rules have not yet adapted. This, we strongly contend, is a key reason for the long-term underperformance of Value indices post the Global Financial Crisis.

Intangibles- a key to investing in today's world

Even though it is impossible to measure the value of intangibles precisely, it is essential for investment professionals to come up with a logical approach to incorporate intangibles into their decision making; otherwise, they risk being relics in this new age of information.

At Insync we have developed a systematic way of incorporating the cashflows that intangibles are delivering into our valuation methodology. This results in a more accurate assessment of the value of a business and a key reason of our successful stock selections.

Over the years I have often sat alongside guests on a TV or radio panel and heard them conclude the easy gains have been made. For the first time in many years I agree.

In recent years investors have made substantial gains from equities but a close look at the driving force behind those gains is likely to reveal investors won because the tide was rising. Sure, many companies grew their earnings too but there were a huge number of companies whose share prices went parabolic despite the absence of earnings. A rising tide does indeed lift all boats, but don't mistake a rising tide for genius, or so the axiom goes.

Since 1979, without exception, every period of inflation and or rising interest rates, was accompanied by a contraction in price to earnings (PE) ratios. And using data back to the 1980s, we find the decline in the earnings multiple is greatest when interest rates move up from lower starting levels, just as we are witnessing now. For the last four decades, whenever inflation or interest rates have risen, the multiple of earnings investors have been willing to pay for a share in a company has declined. In every one of the seven phases when US 2-Year Treasury yields rose between 1980 and today, the US S&P500 12-month forward PE Ratio declined.

In other words, if Jerome Powell and his team at the US Federal Reserve continue on the path articulated in our blog post The End of Zero, investors can kiss goodbye the easy wins resulting from shares simply becoming more popular, and that rising popularity being reflected in ever expanding PE multiples.

I will go so far as to suggest we are, right now, in a period of adjustments to a regime of lower PEs. Plenty of investors haven't yet worked that out and this can be seen in the steep gains for almost all equities amid the hope and talk of peace in Ukraine.

Fundamentally however, rates are rising. And while I think rates will rise by less than the most bearish forecasts, the impact on PEs is already underway.

Going forward

Investors should now be looking at the quality of their portfolios and seek at least some exposure to high quality growth. 

If a company, with earnings of $10 per share, sees its PE of 35 times fall to 25 times, the share price will decline 28 per cent, from $350 down to $250. Plenty of high-quality growth companies have experienced this, and worse. And that represents a new opportunity.

In an environment of high short-term inflation expectations history tells us not to expect expanding PEs. If the best we can hope for is PEs remain static, the way to generate capital growth will be from earnings growth.

If the PE ratio for our hypothetical company stays at 25 times earnings, the share price will return to $350 provided earnings grow 40 per cent to $14 per share (E$14 x PE25 = Px$350).

The work investors need to undertake now is to uncover those companies able to grow.  One place to look is among those companies enjoying structural or megatrend tailwinds.  And if among those companies you also find a capital light and highly profitable business with net cash on the balance sheet, more power to you.

Avoid capital intensive, low growth, mature, cyclical, geared businesses, or those with lumpy contract-type revenues, and those exposed to discretionary spending (unless they are on a store roll-out tear) and those companies playing in the revolving door of capital - paying out cash, they need later, as dividends today and subsequently raising dilutive capital to replace it.

In the next period investors will be wise owning businesses selling products and services with inelastic demand and the recipients of non-discretionary spending. Think of Microsoft - nobody is going to cut their subscription to Microsoft Office just because Jerome Powell said interest rates are going up, or because Putin decides to invade Ukraine. 

Inelastic services like Microsoft Office are entrenched in the daily systems of hundreds of millions of businesses and individuals. That durability provides Microsoft low cyclicality, higher profitability, stable, recurring and growing cash flows and little or no need for debt. 

Another company that comes to mind is held in the Polen Capital Global Growth Fund; Adobe. Adobe's Digital Media products enjoy a near monopoly and are "industry standard".  Adobe creates and markets software for creative professionals and hobbyists. Its digital media segment supplies 70 per cent of revenue and 90 per cent of it is recurring. Meanwhile its SaaS based digital marketing solutions for enterprises produces 24 per cent of revenue, while Print & Publishing is two percent.

In 2011 Adobe commenced a transition to annual subscription-based sales, forever altering the company from a "boom, bust" product cycle business to a predictable, subscription-based model.

Unsurprisingly the company generates a return on invested capital of 33 per cent, a return on equity of 43 per cent, has US$1.1 billion of net cash on its balance sheet, produced earnings growth in 2021 of 23.6 per cent, free cash flow growth of 29 per cent and an operating margin of 45 per cent. They are numbers most businesses owners would be envious of. 

But when Adobe recently announced it was ceasing new sales to Russia and not collecting on subscriptions there, the share plunged nearly 10 per cent. Great!

Since its share price highs last year, the shares have declined 37 per cent. Sure, the rate of growth that saw revenue of US1.6 billion in 2004 rise to US$15.8 billion in 2021 may slow but this is a structural growth story, a very high-quality company and remember, shares prices generally track earnings if the PE remains constant. 

And finally, let us say interest rate rises have the desired effect of reducing inflation. Well, what follows is disinflation and in a disinflationary environment, when the economy is still growing, PEs expand again. That would be icing on the cake for investors who heed the suggestion to invest in quality growth after share prices have been slammed by contracting PEs.

Author:  Roger Montgomery, Chairman and Chief Investment Officer

Semiconductors sell off

The semiconductor pull-back accelerated in March. Investor concerns centred on slowing demand for consumer electronics in the wake of economic pressures brought on by inflation and interest rate hikes. Severe lockdowns in China related to COVID also added to these fears.

Readers will recall that a few months ago we wrote extensively about how semiconductors are playing a burgeoning role for consumers and businesses. We also explained why this trend is likely to continue, driven by secular growth drivers such as Cloud, the Internet of Things and automotive (where silicon content will increase from virtually nothing to 20% of a premium car's bill of materials (BOM) by 2030 - see illustration above). Despite the market's fears, it is worth highlighting that for a majority of our semiconductor holdings, demand still far outstrips supply. This implies that over the short-term any reduction in consumer electronics demand is likely to be taken up by other, new verticals where demand looks set to double, and possibly double again. Given all this we think that the recent sell-off is overdone.

A very simple way to illustrate this point is to compare the forward Price-to-Earnings (PE) ratios of semiconductor companies to that of the broader market (S&P500). That is, how much are investors paying per dollar of a company's earnings in twelve months time. We don't use relative measures like this to drive investment decisions, but much of the market does, so at the very least it's useful as a rough guide. Logically, investors should be willing to pay more for companies that are growing earnings faster, all else equal. But this isn't the case when it comes to many of the key semiconductor companies underpinning much of the world's disruption.

Take Qualcomm for example, a company that is already essential in 5G for smartphones and increasingly so in connected devices (for example dog collars with GPS trackers) and automotive. It is currently trading at a forward PE ratio of 13x and is expected to grow its earnings by 70% in 2022. This compares to the broader market (S&P500) which is trading at a forward PE ratio of closer to 20x and is expected to grow earnings by 15% in 2022. The market is paying almost twice as much for less than a quarter of the earnings growth! In addition, the 13-year discounted cash flow model we maintain on the company confirms this under-valuation.

It is in times like this that our investment philosophy and process provide comfort. Our valuation methodology is informed by how the world is changing and the direction in which it is heading, typically a longer time horizon than that of the broader market. We firmly believe that the market will 'capitulate' on its negative semiconductor stance as key companies continue to deliver exceptional earnings results, evidencing their growing importance across many industries. It is this process that has produced favourable outcomes for clients over the almost eight years we have been managing the strategy.

Semi

We don't invest in Russian companies, and have dramatically reduced our holdings in Chinese companies in the past year, a position which has hardened since the overly friendly deal struck between the leaders of the two countries, Vladimir Putin and Xi Jinping, during the Winter Olympics, and which preceded the invasion of the Ukraine by just four days.

Russia could have been lumped in with investment in the 'emerging markets' asset class, but frankly, it never made the cut. Putin's financial and political relationship with the oligarchs, the bedrock of the kleptocracy, made buying into Russian companies like search engine group Yandex opaque at best.

There were many other reasons as well. He has systematically cracked down on media freedom, jailed political opponents and passed legislation authorising the murder of enemies of the state outside Russia (symmetrical with the powers it had within Russia), which of course resulted in the radioactive poisoning of Putin critic Alexander Litvinenko in the sushi bar of London's Millennium Hotel.

Had we ignored the geopolitics and invested in Russia - on the basis of low financial valuations of many companies - the outcome would have been negative given that the economy has been crippled by the sanctions now being applied by NATO countries and others.

China too has become increasingly difficult as an investment proposition. We first included companies in China because the political environment styled 'socialism with Chinese characteristics' had unshackled the economy and created the super-growth for companies such as Alibaba, which disrupted bricks-and-mortar retail, banking and transport. This also made a material difference to the lives of many Chinese people. Of course, there was always a measure of autocracy, but the balance that was struck allowed enough private enterprise for commerce to thrive and set China on a tear that lifted 850 million people out of rural poverty and into the middle class.

The most obvious marker that there was to be a change was the 2017 crackdown in Hong Kong by President Xi. The situation continued to deteriorate over the following years, and then Xi canned the float of Ant Financial and levied Alibaba with a US$15b fine - a 'common prosperity' payment. Later, China Inc nobbled the ride-sharing company Didi, until that moment a credible competitor to Uber.

At many points in the past five years there was a temptation to suggest the changes in China couldn't get worse. But in October last year Xi upped the ante on Taiwan, flying 150+ fighter jet sorties over Taiwanese air space on the 100th anniversary of the birth of the Chinese Communism Party. The clear message: Taiwan must become part of China again. Sound like Russia's approach to Ukraine?

It's no surprise that the countries with the strongest innovation track records are also those with the most liberal political structures. Ever wonder why South Korea is such a technology powerhouse, while North Korea… isn't? Or why Taiwan's TSMC is the largest and most successful semiconductor manufacturer in the world, while China lags, or for that matter why there isn't a Russian Apple? It isn't that the folk aren't as smart - more a case of where is the incentive to build a great company if it can be appropriated by the state and its mates?

Which is not to say that liberal democracies are motivated by altruism. The semiconductor industry built by William Shockley, then his employees at Fairchild and Andy Grove at Intel was underwritten by the US wish to dominate weaponry and space, requiring top grade guidance systems which required the latest silicon.

Geopolitics and our investment process

For Loftus Peak, as managers of the Fund, geopolitical matters such as these are expressed in the valuation process by the discount rates used to determine entry and exit prices. Companies listed in countries with autocratic political systems mostly attract higher discount rates. This results in the price targets we ascribe to companies operating in these countries being lower and so too the Fund's overall exposure in terms of weighting to those countries. The outcome of this is an absence of holdings in Russia and a low weight to holdings in China, both of which have broadly worked.

Performance and portfolio positioning

An appreciating Australian dollar drove the weakness in absolute performance and the pullback in semis led to relative underperformance against the benchmark of -2.0% in March against our benchmark MSCI All Countries World Index (net, as expressed in AUD from Bloomberg). We believe the market has started to recognise the value of quality companies - those with robust business models, pricing power, strong balance sheets and cash flows. We expect this trend to continue as the macroeconomic environment begins filtering through to company earnings.

We recognise that during times of uncertainty - war, inflation, interest rate hikes - markets tend to focus on that which is directly in front of them (the next quarter, or two). However we take a longer-term view and gain comfort in the Fund's positions knowing their growth is being driven by powerful secular trends that will continue for the next decade and that many of these quality companies are now trading at even more attractive prices. We took advantage of the market lows in March to increase our weighting to equities by around 5%, purchasing a number of quality companies that had been on our watch list but were previously precluded from the portfolio on the basis of valuation. Cash exposure at the end of March was 7.4%.

The Co-Founders of Collins St Asset Management, Michael Goldberg and Vasilios Piperoglou, alongside Head of Distribution & Investor Relations, Rob Hay, are hosting an interactive webinar (existing clients only) where they will be sharing their insights into the investment thesis underpinning the launch of the upcoming Convertible Note Fund.

With capital preservation at the heart of the team's philosophy, Michael and Vasilios will articulate the compelling asymmetrical risk / return outcomes that can be achieved through convertible note exposure and how debt like downside / equity like upside can create the potential for an 8% p.a. yield as well as capital appreciation over the medium term.

The team at Collins St Asset Management have developed deep knowledge and experience in the field of convertible notes, having completed numerous transactions with profits of between 30% and 100% within the flagship Collins St Value Fund since 2016.  Throughout that time the investment process has continued to evolve and be refined to the point where Collins St Asset Management are regularly being introduced to new opportunities with the volume of potential transactions being greater than what could be exclusively accommodated within the Collins St Value Fund.

To that end, and as a natural extension of the same research process that has delivered investors a net return of 19.1% p.a. since inception in the Collins St Value Fund, the team are excited to present this opportunity to you and look forward to your attendance at the webinar.

*Please note that past performance is not a reliable indicator of future performance and ensure you receive and read a copy of the Information Memorandum for the Fund in full prior to making any investment decision with respect to the Fund.  The Fund is available to those investors who qualify as 'wholesale' or 'sophisticated' only.

Speakers: 
Michael Goldberg, Co-Founder
Vasilios Piperoglou, Co-Founder
Rob Hay, Head of Distribution & Investor Relations

Register here!

Thanks to COVID-19 online shopping has catapulted in popularity. Subsequently, so has the Buy Now Pay Later (BPNL) universe. But, with so many BPNL players in the industry, which one do you choose? 

Size does matter and reach is paramount for merchants who want to offer a range of payment providers but must nearly always include bigger players like PayPal.

PayPal wins for merchants and many purchasers because:

1.    PayPal has 396 million customers

2.    PayPal processes approximately 60% of all online retail spending (ex-China)

3.    PayPal thrives without late fee income unlike most competitors 

4.    PayPal is already indirectly in the Chinese market via Go Pay and Shanghai-based Union Pay with potential to reach 500 million Chinese shoppers

5.    Information Technology Resources - PayPal launched its BNPL response far quicker than any smaller player could imagine

Merchants don't want a window full of logo stickers for payment providers and Millennials are too savvy to have a phone full of BNPL apps. They want proven providers when managing their money and money transfers.

Other Global Tech stocks/themes include: NVDIA, Amazon, VISA, Apple Pay, Nintendo, Hydrogen, and Low Emission energy. 

Disruptions stocks can provide investment returns now

Insync's investment strategy concentrates on disruption and its interrelationship with a global Megatrend rather than just investing in disruptive companies.

Our investment philosophy revolves around high quality companies. We look for companies that are benefiting from disruption, have long runways of growth through exposure to global Megatrends and are highly profitable.

Continuing Instability, More War; Credit Excesses.

The war in the Ukraine continues with shocking humanitarian suffering and carnage not seen in Europe in 8 decades. The ongoing war and related sanctions will likely lead to sustained inflation, more market instability and heightened geo-political uncertainties. The reaction of the Russian leadership to any failure on the ground cannot be predicted.

In China, an outbreak of Covid has led to strict lockdowns, with the inevitable economic downturn and possible social unrest. China has her own deflating financial bubble, primarily in real estate: the yields on major Chinese Developers ranged from 15.5% (Country Garden) to 109% (Evergrande). Excess credit leads to instability in all countries.

Real world inflation continues to be an issue - another outcome of credit excess exacerbated by war, Covid and supply-chain problems. Many commodity prices are up double digits, wages are up, and central banks appear to be starting a tightening cycle: the first since 1994, nearly 30 years ago. Most Fund Managers will be seeing one for the first time.

Investors must contemplate multiple scenarios, including current inflation, credit instability, rising default rates, and probable deflation in financial assets.

Inflation and Life Settlements. 

Should Life Settlements be part of investors' portfolios in times of inflation? A rational analysis will begin by establishing three assumptions: expected return on the LS portfolio, expected inflation, and the time horizon.

The expected return of the Laureola LS strategy is 8% to 12%; the actual return in the past few years has been between 6% and 9%. At least this has the validity of being backed by realised gains.

• Let's use 7% as a conservative assumption with a high probability of being realised. (Laureola's portfolio is currently valued at a 13.5% IRR - gross of fees and fund costs, so there is a buffer).
• As for inflation expectations, there are as many as there are investors. Current YOY inflation is above 8%, but the broad market expects inflation to average 3.34% according to the 5-year TIPS auction last week. This has been climbing since April 2020, so let's use 4% to have some buffer above current market expectations.
• Let's use 5 years as the time horizon, as we have the 5-year figure for inflation expectations, LS returns are more reliable over the 3-5 year time frame, and seasoned investors will typically prefer a longer time frame for their decisions.

Mathematically, a 7% return will be helpful, even in a 4% inflation environment. Investors can adjust both figures according to their analysis, but there is a significant buffer. Despite the fixed income characteristics, LS prices are only modestly correlated to interest rates. The IRRs on LS have ranged between 6% and 12% above Treasuries and LS prices have proven to be more dependent on capital flows and liquidity. The prices of LS may vary over the coming 5 years, but the realised return on those already purchased will not be affected. The realised return on LS is reliant primarily on getting the mortality right, and that is why Laureola has such a strong focus on understanding the mortality of each insured. Control for this variable will beat inflation in most scenarios.

Performance and positioning

Investors are concerned about the effects of inflation on their portfolios. There is no doubt a place for assets that directly protect against inflation, such as commodity exposure, real estate, or possible gold. But a portfolio focussed only on these assets may not do well in other scenarios, e.g. more moderate inflation or deflation resulting from a credit crisis. A stable 7% annual return over 5 years will provide investors with 40% more purchasing power 5 years from now.

Laureola has always delivered 7% or better over 5 years and, as the strategy is based on mortality, it brings the added benefits of genuine non-correlation, stability and protection from geo-political and economic shocks.

In some analyst's eyes Tracking Error, which measures how closely a fund follows its benchmark index, provides a useful way of measuring both a fund's performance, and value against the index. It is calculated as the standard deviation of the difference between the returns of an investment (or fund) and its benchmark. The theory is that the more active the fund the higher its performance should be compared with the benchmark, and therefore the higher its tracking error should be. Conversely, the lower the Tracking Error, the more closely the fund follows the index.  The logic seems straightforward enough: Investors in active funds, and paying "active" fees, don't want to pay the fund manager to simply track the index.

Unfortunately the Tracking Error can be a misleading way to evaluate a manager's performance.

A more informative way to look at a fund's performance vs its underlying benchmark or index is to measure its Up and Down Capture Ratio. Once understood, they provide a more realistic measurement of a fund's ability to perform in both positive and negative markets.

The up capture ratio shows the percentage of the market's gains the fund has captured when the market rises. The higher the up capture ratio, the better the fund has performed in positive markets. Conversely, the down capture ratio shows the percentage of the market's losses the fund captures when the market falls. The lower the down capture ratio, the better the fund's performance in negative markets.

So far so good!  However, selecting funds based on their relative up and down capture ratios will also be dependent on the investor's circumstances (age, life cycle), risk tolerance and one's market expectations. 

Down Capture is particularly useful as it indicates the fund's ability to protect capital in falling markets. If an investment loses 20% it needs to gain 25% just to get back to where it started, and if it loses 40%, it needs a return of 66.7% to get back to even. 

As an example, the Collins St Value Fund and the DS Capital Growth Fund both appear in their peer group's highest performance quintile over 3 and 5 years. This is primarily based on their low down capture ratios of 47.6% and 70.5% respectively. Similarly the Bennelong Australian Equities Fund was also in the highest performance quintile, but based on a high up capture of 131.7%. Importantly both DS Capital and Bennelong had low tracking errors compared to the respective peer group. The L1 Capital Global Opportunities Fund returned an impressive 35.51% per annum for the past 5 years by not having a negative return in any month, resulting in a negative down capture ratio of -131%, while also having a relatively low Tracking Error of 11.5.

For most Advisers and Investors it is easy to get lost in a sea of often contradictory statistics that potentially don't tell the full story. It is better to have a high level of diversification, and to concentrate on those statistics that are aligned to your investment goals - whether that be protecting the downside, or making hay while the sun shines!

Federal Reserve Chair Jerome Powell appeared on March 3 before the Senate Banking Committee and vowed the US central bank would quell inflation running at four-decade highs. "We are going to use our tools," he said. Then came a pointed question. Would the Fed be prepared to harm the economy to tame inflation?

To show his intent to smother inflation that has surged to 8.5% (12 months to March), Powell answered "yes" by invoking the last Fed chief to induce a recession to rein in price rises. The Jimmy Carter-appointed Paul Volcker, who was Fed chair from 1979 to 1987, raised the key rate so much - to 20% in 1981 - he triggered two recessions; a fleeting one in 1980 and the slump of 1981-1982 when the jobless rate peaked at a then-post-Depression high of 10.8%.[1] "I knew Paul Volcker," Powell said. "I think he was one of the great public servants of the era."[2]

Volcker was probably the most hated.[3] As the economy slumped, the Fed was subject to protests that still rate the greatest in its history. In-debt farmers on tractors besieged Fed headquarters while car dealers sent coffins full of unsold car keys.[4] Volcker was assigned bodyguards,[5] especially as a man angry at high rates and armed with a sawed-off shotgun burst into Fed HQ.[6]

While Volcker was scorned by industry, the public and politicians (but not the media - why Ronald Reagan reappointed Volcker in 1983), historians have been kind. "Volcker was Jimmy Carter's gift to Reagan," one Reagan biographer wrote. Volcker "squeezed the inflationary expectations out of the economy and put it on the path to solid growth".[7]

Powell says he can achieve the same feat without the Volcker recession(s). He'd better. Though Volcker was on the Fed leadership team from 1975, he bore little responsibility for how inflation was running at 13% when he became Fed chair. (It peaked at 14.8% in early 1980.) Powell, however, is to blame for much of today's inflation for two reasons.

The first is Powell loosened the Fed's inflation guidelines. The Fed in 2020 scrapped a 2% inflation ceiling that had been in place unofficially then since 2012 officially for two decades in favour of an average target of 2%. The change means the Fed will let inflation exceed 2% "for some time" if it has undershot that figure. The move signalled the Fed would refrain from taking pre-emptive steps against inflation. It makes inflationary expectations prone to leaps.[8]  

Powell's other error - one he admits to[9] - was to misdiagnose today's inflation as fleeting.[10] Even though inflation has topped 5% since mid-last year by when unemployment had fallen below 6%, the Fed left untouched a record low US cash rate and persisted with its asset purchases until March this year. The Fed was even purchasing mortgage-backed securities when home prices, which eventually feed into inflation gauges, were soaring at a 20% clip.[11]

Powell's major fightback against inflation kicked off on March 16 when the Fed raised the cash rate by 25 basis points to a range of 0.25% to 0.5%. Powell's other anti-inflation tool is to shrink the Fed's US$8.9 trillion balance sheets swollen by quantitative easing. Such asset sales would boost longer-term bond yields. Powell's third weapon is to talk tough, as he did on March 21 when he said the Fed would raise the key rate "by more than 25 basis points at a meeting or meetings" to beat inflation.[12]

On the day the Fed raised the cash rate, Fed policy-setting board member 'projections' showed they expect to authorise another 11 rate increases of 25 basis points by the end of 2023 that would lift the key rate to 2.8%. Such an outcome would mean the key rate would be below the Fed's inflation projections until the end of 2023.[13] The Fed thus thinks it can douse inflation with negative real rates while the economy will "flourish" in Powell's words[14] and unemployment stays at generational lows. The jobless rate stood at 3.8% in February.

Such thinking contradicts how the Fed's economic models assume a trade-off between inflation and employment. Michael Feroli, chief US economist at J.P.Morgan, ridiculed the Fed's forecasts as "magical, immaculate disinflation".[15]

The models on which the Fed bases policy decisions are Keynesian-based ones[16] where policymakers seek to manipulate demand to influence inflation, employment and economic growth.[17] Powell's biggest problem is the US economy is not just overheating due to excessive demand (due to fiscal and monetary stimulus). The economy is suffering from 'supply shocks' beyond the reach of monetary policy that fan inflation while denting growth.

Count these shudders. Russia's attack on Ukraine has boosted energy, food and metal prices and reduced consumer spending on other items. The West's sanctions against Russia will hasten the reversal of the globalisation that exploited cheap foreign labour to reduce the cost of goods. China's recent lockdown is just the latest to constrain the output of 'the world's factory' and elsewhere. The pandemic-inspired 'reshoring' of production since 2020 has caused shortages. Lockdown populations, deprived of services but flush with fiscal stimulus, bought goods in such quantities that ports, ships, trains and trucks couldn't cope. Populations detained at home boosted demand for technology so much a shortage of microchips is hobbling the production of many goods. A shift to renewable energy is causing 'greenflation', the term for when the supply of fossil fuels falls but demand doesn't. Pandemic-inspired resignations and the decline of working-age populations tied to falling birth rates are pushing up wages (by 6% in the US).[18]

Powell's best hope is the supply shocks ease and inflation recedes without the Fed needing to raise rates. This is the "soft landing" of the Fed projections that Powell says the Fed pulled off in 1965, 1984 and 1994.[19] Next best, Powell might permit moderate inflation and hope to avoid a cost-of-living blowout that would result in stagflation. An option if inflation persists? Powell might have to crush the economy. Ultimately, a credible Fed chair must mimic Volcker.

To be sure, some excess demand the Fed can stifle is boosting US inflation. But how to remove surplus demand without strangling an economy recovering from the covid-19 blows? Hard to calibrate. How much demand would need to be eliminated to tame inflation boosted by supply constraints? Too much. The soft landings Powell cited aren't much solace because in these cases the Fed stopped inflation accelerating, rather than hauled it in.[20] The US economy could enter a downturn irrespective of what the Fed does, if events were to so turn (due to, say, Russian cyberattacks, a sovereign debt crisis in the eurozone or the developing world or covid-22). In an era of record debt and bloated asset markets, Powell need not raise the US cash rate to the level Volcker did to slow economic growth.[21]

But Powell surely needs to do more than the Fed projections suggest. In the balance between aiming for price stability and full employment, the Fed seeking to hold its authority and independence will eventually need to prioritise fighting inflation to keep the trust that Volcker earned against much hostility.

Sidelined central bankers

Charles Goodhart (born 1936) is a UK economist who has split much of his career between the Bank of England and the London School of Economics.[22] Last year, Goodhart predicted that by 2021 higher inflation would become entrenched. Why? Low birth rates and the consequential decline in working-age populations are ending the era of cheap labour and affordable goods. A future of faster inflation (3% to 4% compared with 1.5%) beckons. In the meantime, Goodhart predicted labour shortages, fiscal stimulus and the post-pandemic recovery meant inflation would hit "between 5% and 10% in 2021 - and stay high."[23] Which is what's happened in the eurozone (inflation at 5.9%), the UK (6.2%) and the US.

Goodhart, co-author of The great demographic reversal book released in 2020, is correct that the labour pool in many countries (from China to Germany) is shrinking as the world heads towards its first voluntary depopulation. Whether such a wage-boosting shift is driving today's inflation is arguable. What is clearer is that monetary policy is largely powerless to tackle such inflation, short of a Volcker-destroy-the-economy setting that no one wishes to seek.

Same goes for greenflation. Global efforts to curb the use of fossil fuels, such as Biden's decisions to halt fracking on federal land and block a key oil pipeline from Canada to the US, have helped propel benchmark oil and gas prices. Central banks struggle to ease greenflationary pressures without inducing a downturn that, among other harm, could slow the investment in renewables they seek to promote.

The end of the second great era of globalisation will probably be dated to when the pandemic struck in 2020. Shortages of emergency goods prompted governments to order home the manufacturing of essential medicines and supplies. Lockdowns, especially those in China, that interrupted the production of everything from microchips to car parts motivated firms to rejig supply lines. Russia's invasion of Ukraine in February only further prioritised national security and self-reliance over economic efficiency. The sanctions imposed on Russia, the strictest ever inflicted on a large economy, are inspiring Moscow to seek revenge (the closing of a key oil pipeline and demands European countries pay in rubles for gas), which further boosts energy prices.[24] The sanctions could come with unintended blows for the global economy and, longer term, might encourage autocracies to become less reliant on the US-led financial order. What can monetary policy do to help alleviate inflationary pressures as ties between blocs fade? Not much. Higher interest rates could even be harmful if they slow investment that could relieve shortages.

Wars usually cause inflation because production is interrupted, transport is disrupted, resources are diverted, young workers are deployed to the military and many are killed and maimed, civilians are killed and become refugees as they flee battlegrounds, and capital goods are destroyed.[25] The OECD in March said the war in Ukraine is likely to lop more than 1 percentage point from global economic growth this year while lifting world inflation by 2.5 percentage points.[26] (Late 2021, the OECD predicted the global economy would expand by 4.5% this year while consumer prices would rise by 4.2%.) Successful peace talks would dampen inflation pressure far more than any action central bankers could take.

China's latest lockdown has only added to policymaker angst about hampered supply. How can central banks tackle inflation stemming from health restrictions without damaging the economy? They can't.

In a world where supply constraints are driving up prices, central banks must choose between inflation and growth (especially in the absence of politically led appropriate solutions to supply-side inflation such as using fiscal policy instruments (taxes and transfers), microeconomic reforms, industry policy, trade policy and diplomacy (in the case of the Ukraine war, and a better health response in the case of China and covid-19). Two big differences between Volcker's world and that of today are the mammoth increase in debt (government, corporate and household) and the financialisation of the global economy that means asset markets hold larger sway over the economy. The marginal impact of each increase in interest rates is greater, especially if asset prices are stretched.

In any Powell blitz against inflation, the cash rate won't have to increase as much as some people might think to trigger a Volcker-like bludgeoning of the economy.

Author: Michael Collins, Investment Specialist